You found the one. You’re convinced. You’re buying a car.
Now – how do you pay for it: cash or loan? Well, that depends entirely on your circumstances. First off – do you have enough cash to pay for the full amount? Let’s say you do. So why would you choose to fork out all that cash instead of getting car finance over several years and keeping hold of your hard-earned lump sum?
[Related: How to get the best deal on a secondhand car]
1. Are you making a return on your cash?
For a start, if you have the cash in an account or under your mattress not earning interest at all, paying cash could be a very good option for you. Think about it: you have cash just sitting there which you could use instead when buying a car, thus avoiding paying interest on a car loan which would total a minimum of 2.25 percent of your car value. On a car costing $50,000, that’s $1,125 per year of interest over five years – which comes to over $5,000 extra you would spend on your car to get a car loan. If the cash is earning interest at a higher rate than the rate of your car loan, it makes sense to keep the cash earning the higher rate and take a car loan at a lower rate. The interest on the cash you have would then be paying off the interest on your car loan.
2. Do you need the comfort of an emergency fund?
If you are the kind of person who needs the comfort of having a stack of cash for a rainy day then a loan is better for you. If you were to pay in cash and use up all your savings, you’d have no emergency fund unless you sold your car in a hurry – which would probably mean you’d lose a lot of it’s value for a quick sale. For peace of mind, many people prefer to keep their savings intact and pay the interest on a loan, knowing they have access to liquidity whenever they need it.
3. Do you prefer to manage your cashflow?
Look at your finances and at how much money is coming in as income and how much is going out as expenses. If you do not have a lump sum to pay off your car straight away, your only option would be to take a loan, as it will help you with your cashflow; the only lump sum you need will be the down payment, which is required on all car loans (not applicable to Ijarah products). This would give you some more breathing space to slowly pay off your car over three to five years. However, remember there is always a risk when you are taking on debt. You need to make sure that you are covered in unforeseen events such as loss of job, critical illness etc.
4. How much debt do you already have?
You may not even have the choice of taking out a car loan, due to your debt-burden ratio (DBR) – the proportion of your income going out in repayments each month to cover all your debts – and the bank will decide whether they would lend more to you based on this. For example, if you earn $5,000 each month and $2,500 is going towards paying off existing loans and credit cards, your DBR is 50 percent. Banks will be careful before they lend you any more if you have a DBR that is above their requirements as they deem you to be a lot riskier than others who do not have current debts. In this case, you may have to buy your car in cash.
5. Are there any zero percent deals available?
You can get some really good deals on loans if you’re buying a car, especially during Ramadan or shopping festivals. Very often, banks offer zero percent deals on financing for the first three years, which could be a very good option; it saves you three years of interest payments without having to use up your savings. However, be sure that you check the rate after the three years are up, and whether you can pay off your loan early during that zero-percent, three-year period so you can avoid getting hit with future interest. The rate after three years might be quite high – and therefore eventually zeros out the three-year interest-free deal. [Related: Why shopping around for a car loan pays off]
The choice between taking a loan or putting up the full cash amount when buying a car is an individual choice and depends highly on your circumstances. Remember, whichever option you pick, always calculate the full cost of taking a car loan versus the cash you would normally put up now – it’s all down to the opportunity cost for you.